Hostess is bankrupt … again

FORTUNE — Those Twinkies on your cupboard shelf may last forever. But the company that makes them may not.

Hostess Brands — the owner of such iconic lunchbox snacks as Ding Dongs, Ho Hos, Suzy Q’s, Dolly Madison Zingers, and Drake’s Ring Dings, as well as Wonder Bread and the “Golden Sponge Cake with Creamy Filling,” the 150-calorie food-science marvel called the Twinkie that drove Woody Harrelson mad in Zombieland — is in federal bankruptcy court. Again. It’s the second time in a decade — which is why bankruptcy wags say the company is in “Chapter 22” rather than merely Chapter 11. Loaded down, astonishingly, with nearly $1 billion in debt, privately held Hostess faces oblivion if its creditors, owners, and unions can’t agree on how to restructure.

So far, in a courtroom near Manhattan and in a negotiating room in downtown Washington, they haven’t come close, although a deal could happen even as you read this. The dramatis personae are impressive: the Teamsters; two large hedge funds, Silver Point Capital and Monarch Alternative Capital; and the private-equity firm Ripplewood Holdings. In an acrimonious behind-the-scenes war — refereed by a federal judge — they wage hostilities over who will get what crumbs from a disintegrating corporate cookie; whether that business can and should be resuscitated; the degree to which fabulous pension plans are anachronistic; whether promises made in collective bargaining ought to be sacrosanct; and just how important it is to save 15,000 union jobs. “There aren’t great options here,” former U.S. House Majority Leader Dick Gephardt told Fortune. Gephardt is now a lobbyist and consultant with connections to Hostess and the Teamsters. “People will have to pick the one that’s a little bit better.”

The Hostess story is a microcosm of larger economic and political issues on the national stage, including the perils of debt and the inertia of unions on workplace reform. It unfolds during an electoral campaign in which President Obama is seeking to make an issue of the supposed predatory excesses of private investment funds, linking Mitt Romney’s career at Bain Capital to the destruction of jobs.

But in truth there are no black hats or white knights in this tale. It’s about shades of gray, where obstinacy, miscalculation, and lousy luck connived to create corporate catastrophe. Almost none of the parties involved would speak on the record. Still, it’s clear from court documents and background interviews with a range of sources that practically nobody involved can shoot straight: The Teamsters remain stuck in a time warp, unwilling to sufficiently adapt in a competitive marketplace. The PE firm failed to turn Hostess around after taking it over. The hedgies can’t see beyond their internal rates of return. Et cetera, et cetera, et cetera.

The critical issue in the bankruptcy is legacy pensions. Hostess has roughly $2 billion in unfunded pension liabilities to its various unions’ workers — the Teamsters but also the Bakery, Confectionery, Tobacco Workers and Grain Millers International Union (which has largely chosen not to contest what Hostess wants to do — that is, to get out of much of that obligation). If the bankruptcy court lets Hostess off the pension hook — which often happens in these cases — it only moves the struggle outside the courthouse, and the ante goes up. For the Teamsters can then call a strike — which its Hostess employees have already ratified by a 9-to-1 margin. If the court doesn’t grant relief, Hostess can seek liquidation, which would mean that some creditors get some money, but equity would be gone for good, as would a lot of jobs. Either way, each side holds a nuclear warhead with which to annihilate the company.

It is an exquisite game of chicken, and neither side may change course.

The Hostess name dates to the 1920s, when the Continental Baking Co. in New York City sold “Wonder” bread goods and “Hostess” cake products. Through a series of mergers, Continental became the largest commercial bakery in the U.S. Over the decades, the business has been owned by such conglomerates as International Telephone & Telegraph and Ralston Purina, which sold it to Interstate Bakeries Corp., which launched another round of acquisitions. Recognizing the power of its main brand, IBC officially renamed itself Hostess Brands in 2009, following the company’s exit from its first bankruptcy. Today Hostess, with headquarters near Dallas, has a workforce of roughly 19,000 — 83% of it unionized — in 36 plants and more than 500 distribution centers across the country. The company remains one of the largest bakeries in the U.S. The Balkanized nature of its empire gave Hostess a piecemeal labor situation, including a matrix of 372 collective-bargaining agreements, a dozen separate unions, 5,500 delivery routes, and no fewer than 40 multi-employer pension plans that are despised by management.

Despite that convoluted history, Twinkies have not much changed since James Alexander Dewar invented them as a Depression-era treat while managing the Continental plant in suburban Chicago. Through the caloric ages, Twinkies developed their own lore and legend. Tens of millions were sold each year. In the 1950s they were a sponsor of Howdy Doody. More recently students at Rice University dropped one from the top of a six-story building, and despite emitting a distinct splurt, the Twinkie barely had a dent. A Twinkie TV commercial became a cult classic: It featured the bandanna-wearing, lasso-twirling mascot Twinkie the Kid, who proclaimed, “You get a big delight in every bite” (plus, of course, a dosage of dextrose, calcium caseinate, sodium stearoyl lactylate, and sodium acid pyrophosphate). There was also the notorious (and unsuccessful) “Twinkie defense” — the idea that eating too much sugar might cause sufficient “diminished capacity” to get an accused murderer off.

While many Americans kept on eating their much-loved Hostess products, the company’s income statement was doing less well. Its fixed-cost structure was a mess. Labor had successfully negotiated generous pensions and health care benefits, but they were out of line with shifts in the marketplace. Hostess sales declined as consumers in the 1980s and ’90s shied away from carbohydrate villains like snack cakes and white bread. Attempts to come up with new products didn’t pan out. It didn’t help that the company had roughly $450 million in debt by 2004. In September of that year, Hostess declared bankruptcy. Enter the cast of moneymen. After five years — unusually long for a reorganization — the company became a private entity, having won concessions from the unions and new capital from investors. The deepest pocket: Ripplewood Holdings, a PE firm based in midtown Manhattan that reportedly once managed $4 billion in capital.

Ripplewood is run by Tim Collins, 55, who’s been at the center of other famed PE transactions. Known as a brilliant capitalist-philanthropist-networker, he’s an eclectic character: a Democrat in an industry of Republicans; an Adirondack enthusiast dreaded by pheasant and fish; a board member at the Yale divinity and business schools; and someone who took a year at 31 to work at a refugee camp in the Sudan. Ripplewood orchestrated the $1.1 billion turnaround in 2000 of the Long-Term Credit Bank of Japan, which marked the first time that foreign interests controlled a Japanese bank. (Collins made the cover of Fortune Asia for it.) The bank was renamed Shinsei, and in 2004 it had a lucrative initial public stock offering. Far less fortunately, in 2007 Ripplewood acquired Reader’s Digest — and saw its $275 million investment vanish in Reader’s Digest’s bankruptcy filing in 2009. (Collins reportedly had visions of merging Reader’s Digest with the magazine division of Time Warner TWX, which owns Fortune.)

Tim Collins, CEO of Ripplewood Holdings

Ripplewood’s foray into Hostess was partly enabled by Collins’s connections in the Democratic Party. He wanted to explore deals with union-involved companies and sought the help of former congressman Gephardt, who in 2005 founded the Gephardt Group, an Atlanta consulting firm that provides “labor advisory services.” In his 2004 presidential bid, Gephardt — whose father was a Teamsters milk truck driver — was endorsed by 21 of the largest U.S. labor unions; in 2003, Collins was one of 19 “founding members” of Gephardt’s New York State leadership committee. (Today, Ripplewood and Hostess are listed online as major clients of Gephardt’s consulting group, which is also an equity owner of Hostess.) Back when Hostess was coming out of the first bankruptcy, Gephardt’s credibility with both Ripplewood and the Teamsters gave them each a little more room to break bread.

During this first bankruptcy, Hostess was almost sold. In 2007 it warded off a $580 million bid from its biggest competitor, Bimbo Bakeries USA. Bimbo Bakeries USA is part of Grupo Bimbo, the Mexican baking giant that owns such brands as Sara Lee, Entenmann’s, Freihofer’s, Arnold, Boboli, Ball Park Buns, and Thomas’ English Muffins. Joining Bimbo in the bid were the union-friendly investment arm of supermarket titan Ron Burkle and the Teamsters themselves.

Hostess was able to exit bankruptcy in 2009 for three reasons. The first was Ripplewood’s equity infusion of $130 million in return for control of the company (it currently owns about two-thirds of the equity). The second reason: substantial concessions by the two big unions. Annual labor cost savings to the company were about $110 million; thousands of union members lost their jobs. The third reason: Lenders agreed to stay in the game rather than drive Hostess into liquidation and take whatever pieces were left. The key lenders were Silver Point and Monarch. Both are hedge funds that specialize in investing in distressed companies — whether you call them saviors or vultures depends on whether you’re getting fed or getting eaten.

Based in Greenwich, Conn., Silver Point was founded in 2002 and has approximately $6.5 billion under management; its two co-founders are 49-year-old Edward Mulé and 47-year-old Robert O’Shea, both former Goldman Sachs GS partners. Silver Point helped bail out Krispy Kreme Doughnuts, Delphi, CIT Group, and various TV stations. Monarch, based in Manhattan, was created in 2008 as a spinoff from the Quadrangle Group. It reportedly has more than $3 billion under management; among its three co-founders are 52-year-old Michael Weinstock and 48-yearold Andrew Herenstein, both formerly of Lazard. Monarch has invested in Eddie Bauer and the Texas Rangers. (In 2010, after Herenstein sent a letter to baseball teams warning them not to approve a sale of the Rangers “at a price below fair market value,” the letter became public, and the Dallas Morning News ran this ominous blog headline: MONARCH ALTERNATIVE CAPITAL THREATENS BASEBALL.)

Silver Point and Monarch, along with about 20 other lenders, owned about $450 million of Hostess secured debt at the time of the bankruptcy filing in 2004, according to court records. Remarkably, though — given that Hostess’s financials are now supposed to be an open book in federal bankruptcy court — it’s unclear how much the lenders actually paid for those notes. But it’s presumably less than face value. Opportunistic investors like Silver Point and Monarch commonly buy distressed debt at a considerable discount. Their strategy: Invest in fundamentally “good” companies that have “bad” capital structures brought about by overborrowing, bankruptcy, or other corporate stresses.

Neither the specific amount put up by each investor nor the percentage of the total debt is public record (In re Hostess Brands, Case No. 12-22052). So it’s impossible to know for sure how much “skin in the game” the creditors have. But according to sources with knowledge of Hostess’s debt structure, Silver Point owns about 30% of the debt; Monarch, also about 30%; and the other lenders combined own the remaining 40%. Clearly, it was Silver Point and Monarch, along with Ripplewood, that had the biggest bets going forward.

To allow Hostess to emerge from bankruptcy in 2009, Silver Point, Monarch, and the other lenders agreed to provide a new secured loan of about $360 million. They also forgave half of the existing $450 million of debt and exchanged the other half — $225 million — for payment-in-kind loans, a kind of financing typically used in high-risk situations. The loans had relatively high interest rates of 8% and 5% (reflecting Hostess’s above-average default risk after bankruptcy). Thus, at the end of the first bankruptcy, Hostess came away not only with concessions from both lenders and unions but with $490 million of fresh capital ($360 million plus Ripplewood’s $130 million) — and Ripplewood’s presumed hands-on operational expertise. Ripplewood had kept the CEO who had led Hostess during bankruptcy, Craig Jung, a longtime veteran from Pepsi PEP. Then Jung left in June 2010 and was replaced by Brian Driscoll, 53, who had held senior positions at Kraft KFT, Nabisco, Nestlé USA, and Procter & Gamble PG. The financiers behind Hostess anticipated that these changes would lead to “profitability and long-term sustainability,” as one put it.

It looked, in short, like a bankruptcy success story — a model of how Chapter 11 is supposed to work. What could possibly go wrong?

Management promised to turn around the company’s fortunes through innovation and workplace efficiency. It tried a limited-edition return of original banana-cream Twinkies and published The Twinkies Cookbook, which included such half-baked epicurean delights as Twinkie Sushi and Pigs in a Twinkie. But ancient delivery trucks and plant equipment didn’t get replaced. The company’s pricing often didn’t keep pace with that of competitors. And Hostess still had ludicrous work rules: The Teamsters had separate drivers for deliveries of such goodies as Yankee Doodles and Nature’s Pride Nutty Oat. (Of course this jobs-preserving work rule was agreed to by Hostess in the last labor negotiation.)

Worse, as the company tried to reinvent itself in 2009 and 2010, external currents were running against it. The Great Recession hurt many consumer brands generally, and the prices of the commodities that Hostess relied on — corn, sugar, flour — went up, which is the opposite of what’s supposed to happen in a downturn. In addition, the bakery industry underwent more consolidation when Sara Lee sold out to Bimbo.

Those fortuities aggravated Hostess’s two root problems — a highly leveraged capital structure that had little margin of safety, and high labor costs. Neither problem was adequately addressed in the first bankruptcy, and neither existed to the same degree in major competitors like Bimbo and Flowers Food (owner of such brands as Nature’s Own and Tastykake). On exiting the first bankruptcy, Hostess’s total debt load was nearly $670 million. That was well above what it went into bankruptcy with in the first place — an unusual circumstance that the company justified on expectations of “growing” into its capital structure.

But the company was dead wrong. Its debt sowed the very seeds of the next bankruptcy. Looking back on the decision to reinvest in Hostess in the first bankruptcy, one of the lenders now says, “If you look in the dictionary at the definition of throwing good money after bad, there should be a picture of Hostess beside it.”

By late 2011, Hostess was getting, well, creamed. Its sales last year — $2.5 billion — were down about 11% from 2008 and down 28% from 2004. (Twinkies remain the best individual seller — 323 million of them in the 52-week period ending June 29, give or take a splurt.) Overall, Hostess lost $341 million in fiscal 2011, 2½ times the loss of the prior year — and by early 2012, primarily because of burgeoning interest obligations, its debt had grown to about $860 million.

As revenue declined, the company continued to burn cash — in the second half of 2011, the rate was $2 million a week. The liquidity crunch forced Ripplewood in the early spring of 2011 to pump in $40 million more in return for more equity as well as debt that was subordinate to that held by Silver Point and Monarch. In August — to save a company teetering on the edge of fiscal calamity and forced liquidation — Silver Point, Monarch, and the group of other lenders put up an additional $30 million to see if a negotiated turnaround was possible.

They turned to the unions and demanded new concessions. But the unions, having three years earlier given up thousands of jobs and millions in benefits, flatly refused.

The company was going to pieces — again — and Hostess filed for Chapter 11 protection — again — in January of this year. This time, though, the moneymen were no longer on the same page. As the majority equity holder, Ripplewood badly wanted to keep Hostess out of bankruptcy. It pleaded with the lenders to show flexibility, but they were not so inclined. They lenders held superior fiscal hands and had less downside if Hostess failed. In the event of a bankruptcy, given all the assets Hostess owned, the lenders would still walk away with millions.

Silver Point, Monarch, and the other lenders now ponied up another $75 million to keep Hostess going while its restructuring adviser, Perella Weinberg Partners, hunted for new equity sources or perhaps an outright buyer, such as one of the other big bakeries. The $75 million — at an interest rate of at least 15% — was on top of that $860 million ocean of debt (and $1.4 billion of liabilities, compared with less than $1 billion in assets). The company had 100,000 unsecured creditors, ranging from United Parcel Service UPS to the Dubuque Advertiser to a CVS pharmacy in Woonsocket, R.I., as well as crucial claimants like the unions and pension funds. One could ask why any lender at this point would invest another nickel in a company awash in debt, but that’s the way bankruptcy law works: This $75 million — super-secure “debtor in possession” (DIP) financing — invariably gets paid back because it is on the top of the pile of secured loans.

Even as it played the numbers game, Hostess had to face chaos in the corner office at the worst possible time. Driscoll, the CEO, departed suddenly and without explanation in March. It may have been that the Teamsters no longer felt it could trust him. In early February, Hostess had asked the bankruptcy judge to approve a sweet new employment deal for Driscoll. Its terms guaranteed him a base annual salary of $1.5 million, plus cash incentives and “long-term incentive” compensation of up to $2 million. If Hostess liquidated or Driscoll were fired without cause, he’d still get severance pay of $1.95 million as long as he honored a noncompete agreement.

When the Teamsters saw the court motion, Ken Hall, the union’s secretary-treasurer and No. 2 man, was irate. So much, he thought, for what he described as Driscoll’s “happy talk” about “shared sacrifice.” Hall says he tracked Driscoll down by phone and told him, “If you don’t withdraw this motion, these negotiations are done.” Hostess withdrew the motion a few weeks later when Driscoll left — the same Driscoll who, Hostess told the court in its motion, was “key” to “reestablishing” Hostess’s “competitive position going forward.” Abbott and Costello couldn’t have made this stuff up if they’d gone to Wharton.

The board replaced Driscoll with Greg Rayburn, a restructuring expert Hostess had hired as a consultant only nine days earlier. Rayburn was a serial turnaround specialist who had worked with such high-profile distressed businesses as WorldCom, Muzak Holdings, and New York City Off-Track Betting. He became Hostess’s sixth CEO in a decade. Within a month of taking over, Rayburn had to preside over a public-relations fiasco. Some unsecured creditors had informed the court that last summer — as the company was crumbling — four top Hostess executives received raises of up to 80%. (Driscoll had also received a pay raise back then.) The Teamsters saw this as more management shenanigans. “Looting” is how Hall described it in TV interviews.

Dick Gephardt, former House majority leader and current CEO , Gephardt Group

Rayburn announced that the pay of the four top executives would go down to $1 for the year, but that their full salaries would be reinstated no later than Jan. 1. Hostess pays Rayburn $125,000 a month, according to court filings. At the same time Rayburn became CEO, Gephardt’s son Matthew, 41, the COO of the Gephardt Group, was put on the Hostess board as a $100,000-a-year independent director.

Away from the sideshow over executive pay, the parties continued to wrangle in bankruptcy litigation. They’ve been at it for months, in court and in closed-door negotiations. On one side are the Teamsters, and on the other are the two hedge funds, Silver Point and Monarch. Ripplewood is pretty much out of the picture by now, except to the extent it can eventually persuade the bankruptcy judge to toss it a bone. While Ripplewood retains some debt, its equity is so far under water that it might as well be gone. It doesn’t attend negotiating sessions with the Teamsters — such is the view from the bottom of the sea. Hostess is at the table but has resigned itself to being a mediator of sorts, with its interests subordinated to the hedge funds, which hold the senior secured debt.

What the hedge funds want is some degree of capitulation from a union whose members will otherwise lose thousands of jobs in liquidation. If the hedge funds don’t get it, they’ve concluded, the company isn’t worth saving. Without the hedge funds’ blessing, no Hostess turnaround is possible. Right now, according to sources with knowledge of Hostess’s debt structure, Silver Point and Monarch each hold Hostess obligations with a market value of between $50 million and $100 million. Those sources also say each hedge fund probably paid somewhere between $125 million and $175 million for that debt. So even with losses to date, both hedge funds have ample skin in the game — skin they’d like to get out of the game sooner rather than later. Of course, if the hedge funds again forgive sizable debt, they’ll probably want sizable equity in return this time.

Finally, there are the woebegone Teamsters. They have plenty of skin as well — and feel as if they’ve been fleeced out of almost $100 million from Hostess after the company “temporarily” ceased making union pension contributions last August. That move by Hostess was a breach of its collective-bargaining agreement with the unions. The Teamsters’ leadership has fulminated to its membership about the hedge funds in particular. “The financial folks make a living of feeding off distressed companies,” Hall says. “They lose sight of the fact that there are real families with livelihoods at stake.” At local unions across the country, the hedgies have become the devil incarnate.

In trying to shed costs, Hostess is gunning for what are known as MEPPs — multi-employer pension plans — which it is required to participate in under its labor agreements with the unions.

MEPPs, which grew in popularity back in the union glory days of the 1950s and ’60s, were designed for companies within an industry to share pension burdens. There are nearly 1,500 MEPPs in the country, covering more than 10 million workers. These mammoth defined-benefit plans — employers, not workers, make the contributions — were especially attractive to unions, as they allowed workers to move easily between companies.

Trouble with MEPPs is, if some employers go out of business, the remaining companies have to pick up the shortfall in funding benefits. When there are too few employers left standing, the fund is in trouble. According to a March research report by Credit Suisse, MEPPs are now underfunded by $369 billion. A third of the 40 MEPPs to which Hostess contributes are among the most underfunded plans in the country.

At the bargaining table, week after week, Hostess and the Teamsters have gone at it over the MEPPs, which Hostess contends are at the heart of its woes. Perella Weinberg’s Michael Kramer has squared up against Harry Wilson, the financial adviser retained by the Teamsters. Monarch’s Herenstein has been there. So has a representative from Silver Point. Though all are cordial — somebody once served Hostess snacks — they’ve yet to achieve a middle ground.

Gregory Rayburn, Hostess CEO

Hostess has proposed having workers themselves contribute to a single pension plan or, alternatively, switching to a pension arrangement in which Hostess would contribute to only a handful of MEPPs. In the latter proposal, Hostess’s annual contributions would go down from the required $100 million to $25 million or so. (If Hostess is allowed to pull out of the MEPPs, the plans would have claims against the company, but as unsecured creditors they would come away with little or nothing.)

While the Teamsters have rejected that proposal, they’ve indicated a willingness to accept reduced contributions — but only with the current MEPP structure in place. In April the Teamsters offered a pension holiday until next spring, and then a contribution level of 45% to 60% over the remaining three years of the collective-bargaining agreement. Hostess says that even that half a loaf is untenable. In May the bankruptcy judge appeared to share that view, ruling the current pension arrangement “creates too much uncertainty for any entity willing to commit substantial amounts of capital … to turn this company around.”

Hostess has also complained that the Teamsters, who have 1.4 million members overall, might be sacrificing the interests of 7,900 Teamsters workers at Hostess to the long-term interests of the union as a whole. Even if the union can reach a deal with Hostess and investors, all parties would still have to turn to the wage concessions and work-rule changes that the company insists on — and in return for which the Teamsters want a piece of the company. The Devil Dogs will be in the details.

It’s a miserable state of affairs, even as both sides as recently as mid-July professed optimism that a settlement might be near. But despite the mercy that bankruptcy law permits, perhaps the staggering Hostess zombie in the financial graveyard ought not to be fed anymore. While Hostess may yet come out of bankruptcy again — and Twinkies surely will still be made by somebody regardless — a different conclusion seems right: At long last, Hostess may have reached its ultimate expiration date.